This fable was written to demonstrate the difficulties involved in allocating
overhead to divisional units. The fable also shows the arbitrary nature of
overhead allocation, as well as its lack of importance in overall profitability.

The fable begins at the door of a supermarket chain. An accountant meets an old acquaintance, Hal, who is a banker and trustee of an
estate. The estate that Hal is responsible for consist of a five-store grocery
chain. The recently deceased owner of the grocery chain bequeathed the chain to
his wife, however, the grocery chain isn’t making a profit and consequently
the wife is not receiving any income. Hal wants the accountant to attend a
meeting with all the store managers and help evaluate the stores. The accountant
reluctantly agrees to help.

The Grocery Chain

The grocery chain consists of five stores spread around five nearby cities.
These five stores share a central warehouse, as well as a general office. Each
store on an individual basis makes a profit:

However, once the warehouse and general office overhead is subtracted the
company as a whole just breaks even. All that is earned at the local level is
eaten up by the warehouse and general office expenses:

The meeting takes place in the general office of the grocery chain. Attending
the meeting are Hal, the accountant, the five store managers, and the treasurer.
Hal’s main preoccupation is finding the most accurate method of allocating the
overhead so that he can identify the problem store(s) and "fix" them.
Each manager, however, has their own interpretation of how the shared overhead
should be allocated among the stores. Consequently, each store manager’s
interpretation results in the most profit for their store, little profit for one
or two other stores, and huge losses for the remaining stores. Below is each
manager’s overhead allocation, followed by his or her reasoning for said
allocation.

Measured service charge for warehouse and delivery; sales volume for
general office.

Eck

Historical expense increase for store units added.

Ash argues the all the stores benefit equally by having a central
warehouse and office. Because all the stores benefit equally, all the stores
should share the same burden. Therefore, all the stores should be allocated an
equal share of the overhead.

Budd agrees that all the stores benefit equally, however he believes
differences in store size should be recognized in spreading overhead costs
around. Reasons being the larger stores place a greater burden on the warehouse
and office, whereas the smaller stores place less of a burden. As a result, the
stores should be allocated overhead on the basis of sales volume.

Clay argues that he is being cheated. Clay purchased a property with
excellent growth prospects and a cheap rent. But he is charged a theoretical
rent based on appraised value rather than actual rent (which for Clay is much
lower). He believes the overhead should be adjusted to reflect this.

Dan believes the individual stores should be charged with central
facility expenses in proportion to their individual usage of the facilities. He’s
fine with sharing equally in general office expenses, but he wants warehouse
costs to be allocated based on number of deliveries made.

Eck, who was the most recent store added to the chain, believes that
overhead should be allocated based on the incremental increase in overhead for
each store added.

The Accountant’s Analysis

After listening to the store manager’s argue their points, Hal turned to
the accountant and ask him for his advice. The accountant said, "compute
each store’s percentage of total store profit, and then distribute the
overhead on those percentages." This is akin to an income tax; your
overhead is a result of your ability to pay. One of the store managers blurted
the obvious fact that no store would show a profit under this method. The
accountant gleefully agreed.

The Accountant’s Closing Thoughts

"All allocations discussed at the meeting have some merit," said
the accountant. "They all bring out factors that are important, but if you
publish the results for individual stores, calculated on any basis, someone is
bound to get the wrong impression and come to a wrong conclusion." Hal then
asks, "how do I make money in a chain of stores. How do I find which store
is profitable and which is not?" The accountant presented the following
thoughts:

Making money has very little to do with allocating overhead
costs. As is plainly obvious in the meeting, any allocation technique is
inherently arbitrary.

Each allocation method serves some purpose, but not all
purposes.

Trying to evaluate a company on a unit basis won’t lead to a
helpful conclusion. Due to synergies, the whole can’t be evaluated solely
by looking at the parts.

He draws an analogy to Chop Suey. You don’t derive pleasure
from the individual ingredients: the tidbits of pork, the bean sprouts, the
water chestnuts, the soy sauce, etc. You possibly may not even enjoy each item individually. Only as a whole, when mixed by a good chef, do you get a
tasty meal. Furthermore, evaluating each ingredient independent of one
another would lead you to results that are not consistent with the final product.

You shouldn’t let the evaluation of the mixture lead you to a misevaluation of the individual elements.

The accountant further expounds that any allocation will have
its pros and cons. Rating and evaluating performance based on an arbitrary allocation will result in supporters and vocal dissenters. It will polarize the
individual units and compromise the whole enterprise.

Towry, K. L. 2003. Control in a teamwork environment: The impact of social ties on the effectiveness of mutual monitoring contracts. The
Accounting Review (October): 1069-1095. (Towry discusses Social Identity Theory and how it can be applied to vertical and horizontal incentive
systems). (Summary)
and (JSTOR link).